The Hagans View: Who Else Has a New Respect for Capital Preservation Strategies?

“The first rule of investing is don’t lose money; the second rule is don’t forget Rule No. 1.”

Those who took Mr. Buffett’s words to heart were better protected in the past year’s drawdowns than those of us who chased returns. Of course, asset allocation’s reputation as the basic capital preservation tool has taken quite a beating, the naysayers claiming “correlations go to one in times of stress” and “buy and hold is dead.”

But correlations didn’t actually go to one, of course–they simply got closer to one. Correlations between international and domestic equities did increase as the markets plummeted, but correlations between other asset classes (e.g., treasuries vs. equities, gold vs. equities) actually decreased. Many other correlations (e.g., high quality corporate bonds vs. equities) didn’t decrease, but they still stayed relatively low. The bottom line is, asset allocation during the recent market crashes didn’t work as well as many people hoped, but it still performed pretty well as a basic capital preservation tool.

The Point Where Investing Performance Meets “Human”

Asset allocation also acts as a buffer against stupid mistakes. Many of us recently learned (or re-learned) two important facts of “behavioral investing”:

A loss of 10% (or 40%) “hurts” a lot more than a gain of 10% (or 40%) “feels good”. (This is known as loss aversion.)

Of course, many investors integrated these facts into their investing strategies at precisely the wrong time (selling equities and going into cash or bonds at the March lows), forgetting another Warren Buffett gem that would have served them well:

“Be fearful when others are greedy, and be greedy when others are fearful.”

Still, even those who “timed” the market at precisely the wrong time, are probably sleeping better through the recent roller coaster rides of Mr. Market. An asset allocation strategy with a bias towards capital preservation is a boon to those of us whose emotions affect our investing (hint: that’s pretty much all of us). Say you’ve recently switched to a “Ben Graham portfolio” of 50/50 asset allocation between high-grade investment bond ETFs and US equity ETFs. If the S&P gains 20% in a month, you feel fine–your portfolio is up by 10%. You probably feel more than “half as happy” as your friend with the all-equities portfolio. But if the S&P has a 30% drawdown, you feel less than “half as panicked” as your friend with the all-equities portfolio. And your asset allocation ensures you’re less likely to do something stupid–like sell all of your equities and go to cash–and instead encourages you to do something smart: rebalance when one asset class swings to an extreme relative to the other asset class.

So Who’s Taken Their Medicine–And Who Hasn’t?

This bias towards avoiding loss–rather than maximizing gains–requires a shift in the investor’s mindset. When capital preservation is priority number one, the investor puts an increased focus on issues like inflation, expenses, and savings–as opposed to “chasing returns”. And if you think this is only an issue for less sophisticated retail investors, think again; a recent article by Stephen T. McClellan shows that even institutional investors are not immune to “behavioral investing traps” that stray away from a focus on capital preservation:

California’s largest pension fund, Calpers, incurred an almost $60 billion loss in its investment portfolio amidst the state’s current financial crisis, similar to many college endowment funds, investing billions in high-risk private equity, hedge funds, emerging markets, real estate, and toxic assets. But in Calpers case, it seems to have learned nothing about risk from that debacle. In appointing a new head of investments, its strategy now is to pursue further high-risk investments, such as junk bonds and California real estate, to seek higher returns in order to make up the loss. Calpers is not humbled or taking a more cautious approach as the strategy should have been all along. It is still not focused on protection of capital.

Makes you feel good about the future of cash-strapped pension plans, doesn’t it?

The good news is, it’s never too late. If you haven’t made capital preservation a priority in your long term portfolio, now is a perfect time to convert to being a true believer in conservative asset allocation (check out “How to Build a Simple and Effective All-ETF Portfolio” in the ETFdb Library if you want to do so with ETFs). The current market levels seem to have priced in the certainty a robust economic recovery next year, and any deviation will probably make for some pretty nasty volatility. If you can acknowledge how much a major drawdown hurts–and reflect that in your portfolio–I predict you’ll sleep a lot more soundly over the next few years. And you’ll avoid doing anything too stupid.

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